Stop orders have been around for many years, and they are used to "stop" you out of a trade after it has taken a turn for the worst. When you use them to minimize losses in your trading account, you are protecting your remaining capital left in your trade, and the best part of using them is they are automatically triggered, requiring no action from you. The main types of stop orders are the basic stop order, the stop limit order, the trailing stop, and the contingency stop.
The basic stop order is a what you see is what you get stop order. In its most simple form, it is a trigger order that says, "if my stock price hits this price point, then sell my stock."
Contrary to popular belief, a stop order is only sent to the floor if the price objective is met. Many people believe the market makers are sitting at their desks looking for stop orders to fill. This is not true as the orders reside on your broker's system until the certain prerequisites are met. When the stock orders criteria are met, the order is sent to the floor and executed.
A basic stop order sends a "market" order to the floor, which means the order is to be filled as quickly as possible at whatever price. If you are in a hurry to liquidate a position, this is the order you should use, but if you want to guarantee the price you will sell at, the market order is not the one you want to use.
A stop limit order is similar to a basic stop order. It is also a trigger when certain criteria are met and then will send an order to the floor to sell your position. However, with the stop limit, the order that is sent to the floor is a "limit order," not a market order.
Limit orders set a limit to how much you are willing to accept for your trade. For example, if you place a limit order to sell XYZ stock at $34.50, your broker is required by law to make sure that order is filled at $34.50 or better.
At face value, the stop limit is a better order to place because you can control the price at which your position gets liquidated. However, there are some built-in weaknesses to this type of order. Specifically, if the price of the stock can't be sold at your limit price, you will find yourself stuck holding the position.
Have you heard of someone use the phrase "the stock gapped over my stop"? That person is talking about a stop-limit order. It is possible for a stock to move beyond your limit price faster than the trade can be liquidated. In this case, you will continue to hold the position, and it will appear your stop was a worthless transaction.
The stop-limit is not specifically good or bad; it is simply a variation of a stop order. It can be a beneficial order and can help lock in a higher price for your stock, but it can also leave you exposed if the trade moves very quickly against you.
The trailing stop is designed to "maximize profits" by trailing higher and higher with your trade. As the stock moves higher and higher, the trailing stop will automatically adjust to "lock in" more of the profit.
When a trailing stop is hit, it triggers a market order which will sell the position as the fastest available price at that time. Some brokers do allow for a trailing stop limit order, but it is difficult to anticipate where the limit price should be with the trailing stop. So, most people settle for using a market order.
Trailing stops can be beneficial in certain circumstances; however, they falter at actually locking in additional profit. In order for the trail to be triggered, by nature, you will always be selling on a down tick. It is best to trade to a target price and take your profits.
Finally, let's talk about the contingency trigger. Most brokers today allow for a contingency order, which can also be called a criteria orders or conditional orders. It is simply an order that must meet a certain criteria before being sent to the floor to be traded.
There are many uses for contingency orders, but one often overlooked use is as a stop. Think about it this way; a basic stop order is simply a contingency order that says "if my stock hits this price, then place a market order to sell." However, by choosing contingency order instead of stop order it opens up a lot of additional flexibility that a straight stop order is unable to accomplish.
For example: Let's assume you are trading an option on XYZ stock. You want to set a stop for the option based on the price of the stock. This order is not available in most brokers; however, it is available through a contingency order. In this case, you would set up a contingency order that says, "if XYZ stock hits 'x' price, then sell to close my call options at a market order."
Let's be more specific. Assume you are trading AAPL and have purchased some call options. You want to set an order to sell those options if AAPL drops below a certain price. In the order form below, you can see the two parts to the order. Part 1 is the criteria, "If AAPL has a last price that is less than $107.00". Part 2 is the actual order. "Then sell to close my ten call options at a market price."
This script above is essentially the same script of a basic stop order, except this script allows you to place that order based on the stock price, not the option price. Conditional orders are an excellent tool for any trader, but particularly for option traders who want to set a stop based on the stock price rather than the option price.
Regardless of what kind of trader you are, short term, intermediate, long term or day trader, setting a stop should be a crucial part of your trading plan and your capital preservation plan. Like the old saying goes, "failure to plan is planning to fail," we could adapt that and say "failure to trade with a stop is planning to stop trading"